This article was originally published August 14, 2022, under Tri-Macro Research.
The 50 basis point vs. 75 basis point hike in September is a big standoff in the treasuries markets. If the UST markets weren’t underestimating the Fed’s path in 2023, I’d say ok go 50, but markets are discounting cuts next year so if the Fed is serious about bringing inflation down which I think it is and it has said that, they should go 75 basis points in my opinion to set the tone against inflationary market speculation which hasn’t really been reined in.
Treasury markets are very much doubting the path of Fed policy. Nominal and real yields will follow the data until the September meeting – meaning good data, yields up as it just increases chances of either a larger rate hike or persistent inflationary economy – both of which cause yields to rise. The inflationary, negative real yield scenario would include strong data as well and risk assets will have to face rising nominal yields at some point. Inflation expectations are a component into back-end nominal yields. We really haven’t seen the extent of this in the environment where inflation proves more persistent, and Fed policy is ineffective – meaning yields haven’t risen in step with the CPI so there is more catching up to do and yields would go higher if the Fed were to undershoot and raise rates slowly while allowing inflation to persist.
A risk for yields going higher would be recessionary type data in the US which could potentially cause the Fed to pullback into a slower tightening cycle, though even then with the CPI at 8%+ I think it’s not an automatic response. I also think this scenario would not be bullish for risk assets as corporate profits and earnings/multiples fall while the Fed is reluctant to lower the Fed Funds Rate after the latest US inflationary outburst. Nor would a US recession depreciate the USD as it would likely drag down global growth, risk-on currencies and commodity prices.
The dollar shorts really are wanting to see a negative expected-real-yield environment in the US. This would occur under a circumstance of the Fed raising rates too slowly or policy tightening being ineffective in bringing inflation down or a stagflationary situation. Negative expected-real-yield environments are where the inflation expectation rate outpaces nominal yields. Dollar shorts want the spread between nominal UST yields and inflation expectation rates to narrow or invert/go negative, whereas the Fed wants the exact opposite. I think we’ll get the latter.
In both cases of strong data or even baseline growth scenarios where one leads to inflation, and the other inflation comes down – yields would still rise in both as long as there is not a severe US recession. The reason for this is inflation expectation’s component into a nominal yield has completely lagged the CPI meaning lower inflation is already priced in by the market therefore if the CPI falls, it should in theory have a near-zero negative effect on nominal yields. I know this because the breakeven inflation expectation rate on a 10Y Treasury Inflation Protected Security, is around 2.4% while the CPI hovers at 8.5%, far below that of the CPI.
In a truly and persistent inflationary environment in the US the 10Y nominal yield would be at least at 7% in my opinion, driven mainly higher by the inflation expectation component embedded into a nominal yield or long-term interest rate. This makes sense intuitively as the lender wants to at least receive the expected rate of inflation over the term of the loan. We’re slightly below 3% now on a 10Y nominal UST yield while the CPI is at 8.5%. Again – inflation expectations measured by bond market participants are pricing in inflation decelerating significantly, so if it does and oil prices come down, it is not a reason to buy US bonds in my view as that has been priced in.
Markets have very much priced in inflation returning to the Fed’s target. It’s kind of ironic but by “raising rates” it is actually keeping long term UST yields from spiking vastly more on the inflation expectation component – thereby Fed policy is preventing stagflation. The reason is, a 7 or 8 handle on the 10Y with out-of-control inflation eroding US consumer spending would cause a recession in real terms (declines in inflation-adjusted growth accompanied by high rates of inflation known as stagflation).
I think the Fed is very much aware of this risk and that’s why the Federal Reserve is so steadfast on raising rates even in there is collateral damage for risk asset valuations and the global economy. I think we test 4% on 10y UST and see what breaks with the majority of the rise being driven by the real component more affected by Fed policy. In general, I feel the Fed will be successful with their soft landing where inflation slows, asset prices come down, employment and consumer remain strong, though emerging market economies, currencies and equities weaken.
The Fed is also cutting the PBOC China’s central bank time short on fixing their problems. As rising real yields in the US as a result of Fed policy and a stronger USD cause heavier USD denominated debt burdens for the Chinese corporate sector specifically troubled real estate developers. High yield could get very ugly in China to the point where it deters any consumer rebalancing on faltering wealth management products, home prices, asset prices and net worths in China. At the same time unemployment and non-performing loans for banks spike. Lower rates are needed there and a weaker yuan. Though again as I’ve said above the China authorities don’t want to fuel market bubbles either and they are actually very cognizant of this and the effect of low rates on asset prices. So, I feel they are really waiting for a more effective time to move rates lower where it won’t fuel market excesses and is more of an emergency type hard landing move in response to a downturn.
On the inflation report: This really doesn’t alter the Fed’s thinking other than to continue doing what they’re doing. I’ve always been in the camp for inflation to fairly rapidly come back down once it starts to, so the initial peak isn’t unwelcome here. This seems to be the beginning though and I think the initial bullish market reaction is way overdone. Lower oil prices are a sign of a synchronized slowdown in global growth which I think is just beginning and isn’t bullish for equities or risk assets. Everyone knew headline would decelerate just because of oil prices coming down in July, so it’s really not surprising. Core month/month which is arguably the most important figure remained firm at a 0.3% rise following a very major 0.7% rise the previous month. Does this report favor 50 basis point hike over a 75bp hike next meeting? Absolutely not in my opinion, as the Fed will not want to undershoot or even just simply meet market expectations. That would just loosen financial conditions. The Fed wants to tighten which in my opinion means going 75 basis points again next meeting whether the market is anticipating that fully or not.
For example, the market is expecting a 50-basis point increase in September. If the Fed were to go 25bp or even 50bp it could have the opposite intended effect on financial market conditions and thereby fail to rein in inflation or even fuel it higher. Financial market conditions largely reflect nominal and real bond yields, equity prices, USD value against other currencies, and credit spreads between risky and risk-free bonds where narrower spreads mean looser conditions and wider spreads mean tighter.
This is important because financial market conditions are one of the ways monetary policy makes its way into the actual economy. So, if the Fed really wants to tighten financial market conditions and bring inflation down, it has to exceed market-based expectations for interest rates. Otherwise, the effects are nullified because the market is discounting a 50bp hike in September already. The Fed needs to go 75 if it wants to have a tightening effect and continued deceleration in the CPI.